Discussions on the connection between the level of interest rates, incentives to search for yield, and financial stability have been prominent over the last ten years or so. More recently, Larry Summers argued in his 2014 secular stagnation address that the decline in the real interest rates would be expected to increase financial instability. What is the connection between these phenomena?

The 2015 Annual Report of the Bank for International Settlements opened with the following sentence: “Globally, interest rates have been extraordinarily low for an exceptionally long time, in nominal and inflation-adjusted terms, against any benchmark”, adding that “[s]uch low rates are the most remarkable symptom of a broader malaise in the global economy… which has proved exceedingly difficult to understand”. In particular, the report argues that the malaise “reflects to a considerable extent the failure to come to grips with financial booms and busts that leave deep and enduring economic scars”.

Our recent paper (Martinez-Miera and Repullo 2015) tries to face up to the challenge of providing a theoretical model of the connection between real interest rates, credit spreads, and the structure and the risk of the banking system. Specifically, we show how an increase in aggregate savings leads to a reduction in interest rates and spreads, inducing financial intermediaries to search for yield, which ultimately leads to financial instability.

We characterise the endogenous structure of a competitive financial system in which both shadow and traditional banks emerge in equilibrium. We also provide a framework for understanding the emergence of endogenous boom and bust cycles, as well as the procyclical nature of the shadow banking system, the existence of countercyclical risk premia, and the low levels of interest rates and spreads leading to the build-up of risks during booms. Our findings provide a consistent explanation for a number of stylised facts of the period preceding the 2007-2009 financial crisis (see Brunnermeier 2009 for a recollection of some of these facts).

Interest rate spreads and financial sector structure
To analyse the links between aggregate savings, interest rates and financial instability, we focus on the role of banks as intermediaries between entrepreneurs, who need funds for their investment projects, and (uninsured) investors. Banks can monitor entrepreneurs’ projects, which reduces their probability of default but entails a cost for the banks. We assume that monitoring is not contractible, so there is a moral hazard problem, which is the key informational friction driving our results. We show that there are circumstances in which banks choose not to monitor entrepreneurs and others in which they do choose to monitor them. We associate the first case to (shadow) banks that originate-to-distribute, and the second case to (traditional) banks that originate-to-hold.

Our (partial equilibrium) results show that which case obtains depends on the spread between the lending rate and the expected return required by the investors, which under risk-neutrality equals the safe rate. In particular, a reduction in this spread reduces monitoring, and makes it more likely that banks will find it optimal to originate-to-distribute.

To endogenise interest rates and interest rate spreads, we embed our model of bank finance into a general equilibrium setup in which a large set of heterogeneous entrepreneurs that differ in their observable risk type seek finance for their investment projects from a competitive banking sector. We assume that the higher the total investment in projects of a particular risk type, the lower the return, and characterise the equilibrium for a fixed aggregate supply of savings. We show that safer entrepreneurs will borrow from shadow banks while riskier entrepreneurs will borrow from traditional banks.

Aggregate savings and financial instability
To assess whether a global savings glut may have an impact on financial stability, we investigate the effects of an exogenous increase in the aggregate supply of savings. We show that a global savings glut (to use the terminology of Bernanke 2005) leads to a reduction in interest rates and interest rate spreads, an increase in investment and in the size of banks’ lending to all types of entrepreneurs, an expansion of the relative size of the shadow banking system, and a reduction in the monitoring intensity and hence an increase in the probability of failure of the traditional banks. Hence, we have a model that links aggregate savings with the structure and the risk of the banking system.

Although we focus on the effects of an exogenous increase in the supply of savings, the same effects obtain when there is an exogenous decrease in the demand for investment, due for example to a negative productivity shock. Thus, the model provides an explanation of the way in which changes leading to a reduction in the equilibrium real rate of interest, as those noted by Summers (2014), can be linked to an increase in financial instability.

A first extension of our results shows that the effect of a savings glut on financial stability critically depends on the increase in the size of the traditional banks. When banks that originate-to-hold cannot increase their balance sheets, there will be a greater increase in the size of the shadow banking system, a greater reduction in the safe rate, and wider spreads for the traditional banks, so they will become safer. But as soon as these banks are able to relax the constraint, they will become riskier. This result allows us to distinguish between the short- and the long-run effects of a savings glut, and provides a rationale for the idea that the build-up of risks happens when (real) interest rates are ‘too low for too long’.

A second extension deals with the case where investors are risk averse. We show that a reduction in risk aversion has similar effects as a savings glut except for the level of the safe rate, which goes up instead of down, due to the shift in investment toward riskier entrepreneurs that reduces the funds available for safer ones. This provides a simple way to empirically distinguish a savings glut from a reduction in investors’ risk appetite.

Endogenous booms and busts
Finally, we extend our model to a dynamic setting in which the aggregate supply of savings is endogenous. Specifically, the supply of savings at any date is the outcome of agents’ decisions at the previous date together with the realisation of a systematic risk factor that affects the return of entrepreneurs’ projects. For good realisations of the risk factor, aggregate savings will accumulate (the boom state) leading to lower interest rates and spreads, which translate into higher risk-taking. In this situation the economy is especially vulnerable to a bad realisation of the risk factor, which can lead to a crisis (the bust state). The associated reduction in aggregate savings leads to higher interest rates and spreads, which translate into lower risk-taking and a safer financial system. Then savings will grow, restarting the process that leads to another boom and a fragile financial system. In this manner, we can generate endogenous boom and bust cycles.

The dynamic model yields other interesting testable results. First, interest rates and interest rate spreads are countercyclical. Second, during booms the safe rate may be below investors’ subjective discount rate, and it may even be negative. Third, the shadow banking system is highly procyclical. Fourth, even when investors are risk neutral, they behave as if they were risk averse, so risky assets have positive risk premia. Fifth, even when investors’ preferences do not change over time, such risk premia are countercyclical.

Conclusion
Summing up, our research addresses a challenging issue, namely to provide an explanation for the connection between interest rates and financial stability. Specifically, our results rationalise the links between a global savings glut, the low level of real interest rates, and the incentives to search for yield by financial intermediaries. Moreover, the results provide a rationale for a number of empirical facts in the run-up of the 2007-2009 financial crisis.

It should be noted that we abstract from any kind of nominal frictions, which is why monetary policy is absent from our model of search for yield. Introducing nominal frictions would allow studying the connection between monetary policy and financial stability, a topic that merits further research.

David Martinez Miera is an Assistant Professor of finance in the Business Department at Carlos III University. He is also currently the position “Professor Asociado Banco de España” and is an external consultant for the Bank of Canada.

Rafael Repullo is Professor of Economics and Director of the Centre for Monetary and Financial Studies (CEMFI) in Madrid, Spain. He holds a PhD in Economics from the London School of Economics (LSE), and has worked in the Department of Economics of the LSE and the Research Department of the Bank of Spain. He is Fellow of the Econometric Society and of the European Economic Association, Research Fellow of the Centre for Economic Policy Research (CEPR), member of the Financial Economists Roundtable, and founding member of the European Corporate Governance Institute. He has been Executive Vice-President of the Econometric Society and member of the Executive Committee of the European Economic Association, and is currently First Vice-President of the Spanish Economic Association. He has served as Co-Director of the CEPR Financial Economics Programme, and is currently Co-Editor of the International Journal of Central Banking.